Fiscal Policy and the Foreign Exchange Market

Question

Consider a scenario where contractionary fiscal policy is implemented by raising taxes to rein in an overheating economy. What is the expected effect on the foreign exchange market as shown in the graph above?

Accepted Answer

A leftward shift in the demand for domestic currency due to lower domestic interest rates, resulting in a depreciation.

Answer

No significant shift in the foreign exchange market because fiscal tightening does not affect international capital flows.

Answer

A leftward shift in the supply of domestic currency, which would cause an appreciation.

Answer

A rightward shift in the demand for domestic currency, leading to an appreciation.